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What is Capital Asset Pricing Model?

CAPM model is the concept related to risk-return trade off. But before moving ahead why not take a look at these terms – “Risk” and “Return”. It is obvious that risk and return are those words which we generally hear from investors. We know that investors always make investment in expectation of return. The return consists of revenue return as well as a capital gain/loss.This means that “where there is Risk, there is Return”, be it a gain or loss for the investor. Return is always subject to the risk linked with it. The tendency to earn more return increases with the increase in the risk of investment. The risk may arise because of a host of factors: Economical, Social, Political, etc. Some risk can be reduced by diversification. Risk arises whenever the actual return is different from the expected return.

Example of Capital Asset Pricing Model

Let’s try imagining a situation where you have a friend Nick with his money safely deposited in a bank at a return of 5% p.a. On the other hand you have started a new company which is a riskier unit also earns an average of 5% profit for owners or investors per year. Now, the question is Can you convince Nick to draw money from his bank & invest in your company with a same return of 5% p.a.Take a second, and think!

No. You can’t. It’s next to impossible to convince Nick for the same. Nick, being an investor invests in the bank or any other organization in the hope that some benefits will accrue to him in future. If your company is riskier than bank, then Nick would want an average return much higher than 5% p.a.

The same conditions applies when Nick also have some of his money invested in General Stock Market at an average return of 12%. You can’t offer Nick the same return just to persuade him to deal his stock market portfolio with your riskier unit. In that case you would have to offer Nick a bigger return than what stock market is offering. This raises the question that exactly how much average percentage return you should offer Nick to make his investments worth his risk in your company. This percentage is called your Cost of Equity (Ke) and we calculate it by the help of CAPM (Kap-em). This was one of the way investors can be bifurcated into. Basically, investors need to be reimbursed in two ways: Time Value of Money and Risk.

CAPM Model acts as a lead quantifier to measure the relationship between risk and return. It gives a purview to analyze how much additional return an investor should expect by taking an extra little risk. This model assists investors calculate risk and what type of return they should expect on their investment.

Here, Expected return on a risk-free asset can be termed as the risk-free rate which shows the Time Value of Money.

That way, the formula of CAPM becomes:

Expected Return = Risk - Free Rate + Risk

This risk-free rate (rf) showing the time value of money is then added to the other portion of the formula representing risk.

CAPM Equation

The CAPM formula in the above mentioned example factors in Nick’s Risk and his return from other investments & tells us that how much Nick should reasonably expect from your riskier company. That’s why your cost of equity is also called your investor’s expected return.

Ke = rf +[βi (rm – rf)]

Also,

ri = rf + [βi (rm – rf)]

ri

Expected return on an asset

rf

Expected return on a risk – free asset

ßi

Market risk measure

rm-rf

Risk premium

rm

Expected marked return/Market risk premium

Example of CAPM

ri

7%

ßi

1.5%

rm

11%

Therefore, after putting values in the above equation we get,

ri = 7% + [1.5 (11% – 7%)]

ri = 7% + [1.5 x 4%]

ri = 7% + 6%

ri = 13%, In this example, the stock is expected to return, 13%. In short, if the expected return does not make the risk worth it, the investment should not be made.

Who came up with CAPM?

William F. Sharpe took the target that portfolio return and risk are the only components to review and thus he put forth a model that deals with how assets are priced. This model is referred to as the capital asset pricing model; CAPM.

He mentioned this in his book, “A Simplified Model of Portfolio Analysis,” Management Science (January 1963).